Mainstream Acceptance of Cryptocurrency Magnifies Legal Risk Under Securities Laws
In recent days, several major companies have moved toward implementing cryptocurrency transactions in their business. Tesla stated in its recent Annual Report that it had “invested an aggregate $1.50 billion in bitcoin” and expected to “begin accepting bitcoin as a form of payment for [its] products in the near future.”[i] Mastercard announced that it would “start supporting select cryptocurrencies directly on [its] network” in 2021.[ii] And BNY Mellon issued a press release regarding the opening of a new “enterprise Digital Assets unit” to assist customers in their custody and administration of cryptocurrency holdings.[iii]
Despite these strides toward mainstream acceptance of cryptocurrency for use in everyday transactions, there is legal risk under the securities laws, including SEC enforcement risk, surrounding the release and implementation of new cryptocurrencies. The former Chairmen of the SEC and CFTC published a joint op-ed in 2018 stating that the “SEC will vigorously pursue those who seek to evade the registration, disclosure and antifraud requirements of our securities laws” in connection with the issuance of cryptocurrencies.[iv] In the same vein, numerous courts—including in both enforcement actions and private class action lawsuits by investors—have now held that the sales of certain cryptocurrencies may be “investment contracts,” which are securities subject to the securities laws and regulation by the SEC.[v]
The Securities Act of 1933 includes the “investment contract” within the ambit of the term “security,”[vi] but does not specifically define what an investment contract is. The Supreme Court later addressed the definition of “investment contract” in SEC v. W.J. Howey Co., which made reference to the state securities laws that preceded the ’33 Act.[vii] The so-called Howey test defines an investment contract as a “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[viii]
Although sales of cryptocurrencies are not necessarily investment contracts, it is difficult to escape such designation for several reasons. First, a cryptocurrency network will nearly always be a “common enterprise” because purchasers depend on the viability and usefulness of the network to give value to their holdings.[ix] Second, given that recent cryptocurrency announcements have caused significant price movement in bitcoin and other major cryptocurrencies,[x] it may be inevitable that initial purchasers of new cryptocurrencies expect profit as their cryptocurrency becomes more widely accepted. Third, new cryptocurrencies will likely require coordinated marketing efforts to become accepted and useful in the market.
To this end, the SEC released the Framework for “Investment Contract” Analysis of Digital Assets (the “Framework”), which is targeted at cryptocurrency creators looking toward Initial Coin Offerings (“ICO”).[xi] The Framework explains that many of the steps to create a cryptocurrency network and plan an ICO are factors that would lead to the cryptocurrency as an investment contract, including:
The “development, improvement (or enhancement), operation, or promotion of the network”;
The retention of some network “essential tasks” to be performed by an “Active Participant,” or “AP”;
The creation of a market to value to the cryptocurrency; and
The presence of a profit motive for the creator
These factors, along with expected appreciation of the asset, weigh in favor of classifying the cryptocurrency a “security.”[xii] The Framework also explains the conditions that militate against the designation of a cryptocurrency as a security, including:
The network and cryptocurrency are “fully developed and operational” and the asset is immediately able to be used on its network as currency;
The cryptocurrency was created to fulfill a use case for existing users, rather than to generate value through the establishment of the network;
The cryptocurrency’s “prospects for appreciation . . . are limited”; and
The economic benefit generated from the cryptocurrency’s acquisition is merely “incidental” to its use for its intended purpose, and the cryptocurrency is not marketed for potential appreciation
While many cryptocurrencies aim to achieve this “decentralized” structure eventually, many nascent cryptocurrencies may nevertheless initially fail to meet these criteria.[xiii] The SEC has now brought several enforcement actions for failure to register certain cryptocurrencies as securities under Section 5 of the ‘33 Act. The messaging platform operator Kik Interactive (“Kik”), for example, was recently found liable in an enforcement action arising out of its 2017 initial offering of its Kin cryptocurrency.[xiv] Kik, prior to the release of the Framework, specifically told prospective users that by buying into Kin early, they “could make a lot of money.”[xv] Kik also continued to play an active role in the success of Kin by integrating the cryptocurrency into its own and other applications.[xvi] On those bases, the court granted plaintiff’s summary judgment on the SEC’s Section 5 claim.[xvii] While Kik explicitly marketed Kin as an appreciating asset, potential buyers may come to expect that new cryptocurrencies will appreciate as they become more widely accepted in the market. It may thus become increasingly difficult to sell new cryptocurrencies in a manner that does not give rise to an investment contract and, thus, regulation as a security.
Although one SEC Commissioner, Hester Peirce, has proposed a three-year “safe harbor” from securities laws to allow for the implementation of decentralized cryptocurrency networks,[xviii] it is important to note that that is not currently the law. Companies should assess carefully whether cryptocurrency transactions fall within the ambit of securities laws and take appropriate steps in light of such determination, and specifically examine the impact of marketing the cryptocurrency both to potentially buyers and potential adopters.
[i] Tesla, Inc. SEC Form 10-K (Feb. 8, 2021) at 23.
[iv] Jay Clayton and Christopher Giancarlo, Regulators are looking at cryptocurrency, Wall Street Journal, Jan. 24, 2018.
[v] See, e.g., SEC v. Telegram Group, Inc., 448 F. Supp. 3d 352, 379 (S.D.N.Y. 2020); SEC v. Kik Interactive, Inc., -- F. Supp. 3d --, 2020 WL 5819770, at *5 (S.D.N.Y. September 30, 2020); Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340, 357 (S.D.N.Y. 2019); Hodges v. Harrison, 372 F. Supp. 3d 1342, 1348 (S.D. Fla. 2019); Solis v. Latium Network, Inc., No. 18-10255, 2018 WL 6445543, at *3 (D.N.J. Dec. 10, 2018).
[vi]See 15 U.S.C. § 77b(a)(1).
[vii] 328 U.S. 293 (1946).
[viii]Id. at 298-99.
[ix] Known at “horizontal commonality,” the “common enterprise” prong of the Howey test is satisfied where “the pooling of assets from multiple investors [causes] all [to] share in the profits and risks of the enterprise.” SEC v. SG Ltd., 265 F.3d 42, 54 (1st Cir. 2001). It is worth noting, however, that the SEC does not “view a ‘common enterprise’ as a distinct element of the term ‘investment contract.’” See SEC Framework for “Investment Contract” Analysis of Digital Assets at 2 & n.10.
[x]See, e.g. Ryan Browne, Bitcoin hits a record high of nearly $50,000 as major firms flock to crypto, CNBC, Feb. 15, 2021.
[xii]See id. at 2-5.
[xiii] See id. at 9-11 (“Other Relevant Considerations”).
[xiv]See Kik Interactive, 2010 WL 5819770, at *2.
[xvi] Id. at *6-7.
[xvii]Id. at *1.